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Tremendous Tax Savings Opportunity for Certain Investors with the PATH Act

Recent statutory amendments enacted as part of the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) should prompt entrepreneurs to reconsider whether a C corporation may be a better choice of entity than a pass-through entity. For decades, entrepreneurs have rightfully avoided the double taxation of C corporations in favor of pass-through entities, such as disregarded entities, partnerships and S corporations.

The amendments under the PATH Act made permanent the 100% exclusion (subject to certain limitations discussed below) for gain realized on the sale of Qualified Small Business (“QSB”) stock. Additionally, no portion of this excluded gain is treated as an alternative minimum tax (“AMT”) preference item, which means that the sale of QSB stock will not trigger AMT. These changes provide a substantial federal income tax saving opportunity for shareholders able to meet the requirements of Section 1202.

Under Section 1202, a taxpayer, other than a corporation, may exclude the entire amount of gain realized on the sale or exchange of QSB stock issued after September 27, 2010 if the taxpayer has held the stock for more than five years. Prior to the PATH Act, the exclusion percentage fluctuated considerably in recent years, ranging from 50% to 100%. In 2015 the exclusion percentage returned to the original 50% amount and the AMT tax preference item was reinstated. The PATH Act, however, eliminates the uncertainty surrounding these changing exclusion percentages and its treatment for AMT purposes. The PATH Act also clarifies that the Section 1202 gain excluded from income will not be subject to the 3.8% Medicare tax on net investment income that was introduced as part of the Affordable Care Act.

Under Section 1202, QSB stock is any stock in a domestic C corporation originally issued after August 10, 1993 if, as of the date of issuance:

  • the corporation is a “qualified small business” and;
  • the stock is acquired by the taxpayer at its original issue in exchange for money or other property or as compensation for services provided to the corporation.

To be a “qualified small business,” the aggregate gross assets of the corporation at all times on or after August 10, 1993 and before the QSB stock issuance must not exceed $50,000,000 AND the aggregate gross assets of the corporation immediately after the issuance (determined by taking into account amounts received in the issuance) must not exceed $50,000,000.

Stock in a corporation will not be treated as QSB stock unless, during substantially all of the time the taxpayer has owned the stock, the corporation meets active business requirements and the corporation is a C corporation. The active business requirement is met by a corporation for any period if at least 80% (by value) of the assets of such corporation are used in the active conduct of one or more “qualified trades or businesses”. For purposes of Section 1202, a “qualified trade or business” is any trade or business other than:

  • one involved in the performance of professional services in various fields;
  • any banking, insurance, financing, leasing, investing, or similar business;
  • any farming business;
  • any mining business, or
  • any business of operating a hotel, motel, restaurant, or similar business.

A limitation applies in determining the maximum amount of gain eligible for the exclusion. For any one taxpayer, the limitation is the greater of:

  • $10 million, reduced by the aggregate amount of eligible gain arising from dispositions of stock issued by the same corporation and taken into account by the taxpayer in computing the exclusion for prior years; or
  • Ten times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the tax year.

To illustrate how this limitation works, assume that a taxpayer invested $2,000,000 through a private offering in a corporation that was a “qualified small business”. Assume further that after holding such stock for more than five years, the taxpayer sold the stock for $22,000,000. Under these facts, assuming that the corporation met the active business requirement, no portion of the $20,000,000 gain realized on the stock sale would be subject to federal income tax (or AMT).

If you are interested in exploring the potential federal income tax savings available through Section 1202, please do not hesitate to contact one of the attorneys in the Butler Snow Tax Group.

— This blog is co-authored by Blair H. Jussely and Brian S. Masterson

Jussely BlairBrian Masterson